Question

1.

a.

Give a real life example of a negative externality. Explain the Pigouvian solution to a negative externality.

b.

Explain the Coase theorem.

Answer 1

1.

a.

A negative externality is the air & water pollution that is created by the manufacturer in the course of the production process.

A Pigovian tax is a tax placed on any good which creates negative externalities. The aim of a Pigovian tax is to make the price of the good equal to the social marginal cost and create a more socially efficient allocation of resources.

In order to show the Pigouvian solution to a negative externality, consider the following graph. In a free market, the equilibrium will be at Q1 – where Demand=Supply.

Pigovian Tax SMC = S2 P SEPMC Social Efficiency P2 tax P1 Free market equilibrium PO D= PMB = SMB Q2 Q1 Q

At this output, there is social inefficiency. At Q1, the social marginal cost (SMC) is greater than the social marginal benefit (SMB) – there is overconsumption. If the government places a tax equal to the external marginal cost, then consumers will be paying the full social marginal cost. (SMC). This will reduce the demand from Q1 to Q2 and this will be socially efficient because at Q2 (SMC=SMB)

b.

According to the Coase theorem, when there are complete competitive markets with no transaction costs, an efficient set of inputs and outputs to and from production-optimal distribution will be selected, regardless of how property rights are divided.

That means,  if a conflict arises over property rights under the assumptions of complete competitive markets with no transaction costs, then parties will tend to settle on the efficient set of inputs and output.

For example, given that there are zero transaction (bargaining) costs, perfect information, no market power differences, and that the efficient markets for all related goods and productive factors holds;  if a business is subject to a noise complaint initiated by neighboring households, the Coase Theorem leads to two possible settlements. The business may choose to offer financial compensation to the affected parties in order to be allowed to continue producing the noise. Or the business might refrain from producing the noise if the neighbors can be induced to pay the business to do so, in order to compensate the business for additional costs or lost revenue associated with noise abatement.